CHAPTER-I

INTRODUCTION
The funds invested in current assets are termed as working capital. It is
the fund that is needed to run the day-to-day operations. It circulates in the
business like the blood circulates in a living body. Generally, working capital
refers to the current assets of a company that are changed from one form to
another in the ordinary course of business, i.e. from cash to inventory, inventory
to work in progress (WIP), WIP to finished goods, finished goods to receivables
and from receivables to cash.
 DEFINITIONS OF WORKING CAPITAL:

“Working capital is the amount of funds necessary to cover the cost of

operating the enterprise.”
- Shubin
“A study of working capital is of major importance to internal and
external analysis because of its close relationship with the current day to day
to operations of business.”
-Ralph Kennedy and Steward Mc Muller
 DEFINITIONS OF WORKING CAPITAL MANAGEMENT:

Working Capital Management is defined as the management of short-

term liabilities and short-term assets. The process is used continuously to
operate and generate cash flow to meet the need for short-term obligations and
daily operational expenses.
The capital requirements of a business enterprise can be broadly classified
under two categories-
 Fixed Capital Requirements
 Working Capital Requirements
 Fixed capital refers to the capital that meets the permanent or long-
term needs of the business.
Working capital, on the other hand, refers to the capital required for day-
today operations of a Business enterprise. Thus, working capital invested in
current assets keeps revolving fast and are constantly converted into cash and
this cash flows out again in exchange for some other Current assets. Hence, it is
also known as revolving or circulating capital or short-term capital.
“The basic goal of working capital management is to manage the current
assets and current liabilities of a firm in such a way that a satisfactory level of
working capital is maintained.”

MEANING OF WORKING CAPITAL:

In an ordinary sense, working capital denotes the amount of funds needed
for meeting day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing.
Hence it deals with both, assets and liabilities-in the sense of managing working
capital it is the excess of current assets over current liabilities.

NATURE OF WORKING CAPITAL MANAGEMENT:

The objectives of working capital management are two fold:
 Maintenance of working capital
 Ability of sample funds at the time of need.
The basic goal of working capital management is to manage each of the
funds current assets and current liabilities in such a way that an acceptable level
of networking capital is always maintained in the business. These are possible
through proper levels of current assets i.e.; Management of cash, Inventories &
Receivables.
  Management of Cash:
Cash management is one of the key areas of working capital
management. Cash denoted the liquidity position of approach firm, which
plays an important role in nurturing and improving the profitability of an
organization. Hence effective management ensuring adequate cash is
necessary.
 Objectives for Cash Management:

The basic objectives of holding cash management are as follows

 Meeting the payment schedules.
 Minimize funds committed to cash balance.
The purpose of cash management is to focus on the efficiency of management
with which liquidity and cash position is manager.
Cash Planning:
Cash planning is approach technique to plan and control the use of cash.
It protects the financial condition of the firm by developing approach projected
cash statement from approach forecast of expected cash inflows and outflows
for approach given period. The forecasts may be based on the present operations
or the anticipated future operations. The period and frequency of cash planning
generally depends upon the size of the firm and the philosophy of management.
As the firm grows and business operations become complex, cash planning
becomes inevitable for its continuing success.

Cash Forecasting &Budgeting:

Cash Budget:
Approach cash budget is approach summary statement of firms expected
cash inflows and outflows over approach projected time period. It gives
information on the timing and magnitude of expected cash flows and each
balances over a projected period. The time horizon of approach cash budget
may differ from firm to firm.
Short term cash forecasting:
Forecasts covering periods of one year or less than one year is considered as
short-term forecasts. The important functions of carefully developed short-term
cash forecasts are

 To determine operating cash requirements

 To anticipate short term financing
Two most commonly used methods of short term cash forecasting are:
 The receipts and disbursements method
 The adjusted net income method
Long-term cash forecasts are prepared to give an idea of the company’s
financial requirements in distant future. Long-term forecasts may be made for
two, three or five years. The major uses of long-term forecasts are:

 It indicates company’s future financial needs, especially for its working

capital requirements.
 It helps to evaluate proposed capital projects.
 It helps to improve corporate planning

 Management of Inventory:

The term inventory refers to the stockpile of the product approach firm is
offering for safe and compensates that make up the product. In other words,
inventory is composed of assets of business will be sold in future in the normal
course of business operations. The assets which forms store as inventory in
anticipation of need are

 Raw material:

Major inputs (basic) that are converted into finished products.

 Work-in-progress:

That stage of stock that is between raw material and finished products,
i.e., semi finished products.

 Finished goods:

Products ready for sale.

Inventory as approach current assets, differs from other current assets
because only financial managers are not involved. Rather, all the functional
areas, i.e., finance, marketing, production and purchasing are involved. This
inventory management like the management of other current assets should be
related to the overall objectives of maximizing the owners.
Objectives of Inventory Management:
 To ensure continuous supply of raw materials, spares etc, for smooth and
uninterrupted production process.
 To avoid both over stocking and under stocking of inventory
 To invest an optimum level of funds in inventory
 To keep material cost of production so that they contribute in reducing
cost of production and overall costs.
 To eliminates losses due to alter oration, wastage and damages.
 To design proper organization for inventory management. Approach
clear-cut accountability should be fixed at various levels of the
organization.
 To ensure perpetual inventory control solutions that material showing
stock ledgers should be actually lying in stores.
 To ensure right quality goods at reasonable prices.
 To facilitate furnishing of data for short term and long term planning a
control of inventory.
Inventory Management Techniques:
Economic order quantity:
The economic order quantity may be defined as that level of inventory
order that minimizes the total cost associated with inventory management. The
costs with inventories are:
a) Ordering costs
b) Carrying costs / Handling cost
Ordering costs: - Cost associated with purchasing / ordering of materials.
Ex: Transportation, stationary etc.
Carrying costs: - Costs associated with holding the inventory.
Ex: Warehousing storage costs.
By mathematical approach EOQ is calculated by the following equation
EOQ = 2AS/I
Where
A= Annual consumption in rupees.
S= Cost of placing an order
I= Inventory carrying costs unit
 Receivables Management:

Trade credit is considered as an essential marketing tool, acting as a

bridge for the movement of goods through production and distribution stages to
customers. When the firm sells its products services and does not receive cash
for it immediately, the firm is said to have granted trade credit to customers.
Trade credit thus, creates receivables (or) Book debts that the firm is
expected to collect in the near future. The Book debts or receivable arising out
of credit has three characteristics.
First: Involves an element of risk, which should be carefully analyzed. Cash
sales are totally risk less but not the credit sales as the cash payment is yet to be
received.
Second: It is based on economic value. To the buyer: the economic value in
goods (or) services passes immediately at the time of sale, while the seller
expects an equivalent value to be received later on.
Optimum Credit Policy:
A firm’s investment in accounts receivables depends on the volume of
credit sales and collection period. The volume of credit sale is a function of the
firm’s total sales and the percentage of credit sales to total sales is mostly
influenced by the nature of business and industry norms.

Credit policies:

The credit policies decisions of a firm has two broad dimensions:

 Credit Standards
 Credit Analysis

Types of Working Capital:

Types of working capital

Based on concept Based on time

permanent temporary
Gross concept Net concept working working
capital capital
Based on concept:

 Gross concept:

The term gross working capital referred as total current assets. Current
assets are the assets which can be converted into cash with in an accounting
year.

 Net concept:

The net working capital is the difference between current assets and
current liabilities.
Net working capital = current assets - current liabilities

Based on time:

 Permanent working capital:

There is always a minimum level of working capital is required by the

company to carry on its business operations. This minimum level of current
assets is referred to as permanent or fixed working capital.
 Temporary working capital:

This type of working capital keeps on fluctuating from time to time on

the basis of business activities. In other words it represents additional current
assets required for temporary period.

Operating cycle:
It is also known as working capital cycle. Operating cycle indicates that
every time sales do not convert into cash instantly. Some time is required to
convert sales into cash.
The operating cycle is as shown below:

cash

raw
debtors materials

operating
cycle

work-in-
sales
progress

finished
goods

The operating cycle consists of following activities which continues throughout

the life of a business:
Conversion of cash into raw-materials
Conversion of raw-materials into work-in-progress
Conversion of work-in-progress into finished goods
Conversion of finished goods to debtors
Conversion of debtors into cash

Each stage of this cycle require some relevant days for their activity and also
certain amount of investment.

SCOPE OF THE WORKING CAPITAL:

Working capital is the firm’s holdings of current assets such as Cash,
receivables, inventory and marketable securities. Every firm required working
capital for its day-to-day transactions such as purchasing raw material, for
meeting salaries, wages, rents, rates, advertising etc. But there is much
disagreement among various financial authorities (financial managers,
accountants, businessmen and economists) as to the exact meaning of the term
working capital.
Working capital management is one of the most important aspects of
financial management. Working capital management is concerned with the
problems that arise in attempting to manage the current assets, the current
liabilities and the inter-relationship between them. It also refers to management
of short term financing, negotiating administration accounts receivables and
monitoring the investments in inventories. The interaction between current
assets and current liabilities is therefore, the main theme of theory of Working
capital management.
The aim of working capital management is to manage the firm’s current
assets and current liabilities in such a way that a satisfactory level of working
capital is maintained otherwise, if the firm cannot maintain a satisfactory level
of working capital it may become insolvent. The current assets should be large
enough to cover current liabilities.
The terms current assets refers to those assets, which can be converted
into cash within a short period. E.g. Inventory, Resource, Marketable
securities etc. Current liabilities are those liabilities are Products, Bank
overdraft and outstanding expenses.
The interaction between current assets and current liabilities is therefore,
in other words; the goal of working capital management is to manage the
current assets, and current liabilities in such a way that an acceptable level of
net working capital is maintained.
Current Assets
 Cash and Bank Balances
 Short loans & Advances
 Bills Receivable
 Sundry Debtors
 Inventories such as,
  Raw materials
 Work – in – progress
 Finished Goods
 Prepaid Expenses
 Accrued Incomes
 Money receivable within 12 months
The term working capital refers to the networking capital. Networking
capital is the excess of current assets over current liabilities. Current liabilities
are those liabilities, which are intended to be paid in the ordinary course of
business within a short period of normally one accounting year.
Current Liabilities
 Bills Payable
 Sundry Creditors
 Accounts payable
 Short term Borrowings
 Dividends payable
 Stationary liabilities
 Accrued on outstanding expenses
 Bank Overdraft.

CHARACTERISTICS OF THE WORKING CAPITAL:

 It means raw material should be present on the requirement and it should
not be a cause to stoppages of production.

 All other requirements of production should be in place before time.

 The finished goods should be sold as early as possible once they are
produced and inventoried.

 The accounts receivable should be collected on time.

  Accounts payable should be paid when due without any delay.

 Cash should be available as and when required along with some cushion.

MERITS OF WORKING CAPITAL MANAGEMENT:

Positive working capital is the excess of current assets over current
liabilities. In other words, when the net working capital is a positive figure, it is
said that the firm has a positive working capital. It is the situation when the
short term receivable of a company is more than its short term payables. This is
a desirable situation for the company it ensures no bankruptcy circumstances.

 Fight against bankruptcy:

It is an obvious fact that we should have more dollars in pocket than the
list of expenses we have planned. On the similar lines, from a liquidity and
bankruptcy point of view, it is always desirable to have positive working
capital. It ensures more incoming dollars than the planning of outgoing dollars.
If the situation is reversed which is called negative working capital, the
company may face liquidity issues and eventually lead to bankruptcy in case it
is not able to satisfy its short term debt / payables.

 Grab new opportunities:

A company with positive working capital is better positioned to take

advantage of new business Opportunities. Since, the company has available
supplier's support and the additional funds also which are a prerequisite to en
cash the new Opportunities.

 Funds availability from banks:

Under normal circumstances, banks fund only the working capital gap and
not the whole current assets. Working capital gap means net working capital. If
the gap between current assets and liabilities is positive, the bank is keen to
fund otherwise not. As per banks, the company does not require funds.
 CHEAPER FINANCING:
If the current assets are financed by the trade credit i.e. current liabilities,
by forgoing the discount allowed. The cost of trade credit is normally higher
compared to bank finance. It is desirable to take bank finance and avail the trade
discount given by the supplier.

 Helps in maintaining goodwill of the firm.

 Helps in maintaining solvency of the firm.
 Helps the firm in getting regular supply if raw material. Helps the firm in
getting regular return on investment. Helps the firm in getting payment.
 Helps the firm to face the crisis.
 Helps the firm in getting cash discount
 PROFORMA OF THE STATEMENT OF CHANGES IN WORKING CAPITAL:

TABLE-II.1
Particulars As on As on Changes
Previous year Current year Increase Decrease
(in rupees) (in rupees) (in rupees) (in rupees)
Current assets:
Inventories XXX XXX ----- XXX

Cash/bank XXX XXX ----- XXX

Bills receivables XXX XXX XXX ----

Sundry debtors XXX XXX XXX ----

loans and advances XXX XXX ---- XXX

Other current assets XXX XXX ---- XXX

Total current assets(A) XXX

Current liabilities:
Bills payable XXX
XXX ----
Bank over draft XXX
---- XXX
Sundry creditors XXX
XXX ----
Outstanding expenses XXX
Total current liabilities(B) XXX ---- XXX

Net working capital(A-B) XXX

XXX
Net increase/decrease in working XXX XXX XXX XXX
capital
Total XXX XXX XXX XXX
Derived conclusions:
 i. An increase in current assets will increase the working capital.
 Ii. A decrease in current assets will decrease the working capital.
 iii. An increase in current liabilities will decrease the working capital.
 iv. A decrease in current liabilities will increase the working capital.

RATIOS BASED ON COMPONENTS OF WORKING CAPITAL:

The main purpose of ratios based on components of working capital analysis
is:
 To indicate working capital management performance.
 To assist in identifying areas requiring closure management.

The ratios based on components of working capital are as follows

 Current ratio:

Current ratio explains about the relationship between the current

assets and current liabilities.
Current assets
Current ratio = ------------------------------
Current liabilities
 Quick ratio:
Quick assets are those assets which are immediately
convertible into cash. Quick ratio explains the relationship between
current assets and current liabilities

Quick assets
Quick ratio = ------------------------------
Current liabilities
Where, Quick assets = current assets –stock-prepaid expenses.
 Working capital turnover ratio:

The working capital turnover ratio indicates the number of times

the working capital is turned over in the course of a year. It measures the
efficient utilization of working capital .this can be calculated as follows
Sales
Working capital turnover ratio = ---------------------------------
Net working capital

Net working capital = current assets – current liabilities

 Net profit ratio:

Net profit is obtained when operation expenses, interest and taxes

are subtract from gross profit. Net profit ratio establishes a relationship
between net profits and sales this ratio is overall measure of the firm’s ability
to turn each rupee sales into net profit.

Net profit after tax

Net profit ratio = -----------------------------------
Net sales
 Inventory turnover ratio:
Inventory turnover ratio explains about the efficiency of the firm in
producing and selling its products. It is calculated by dividing cost of goods
sold by the average inventory.
Sales
Inventory turnover ratio = ---------------------------
Average inventory
 Inventory holding period:

Holding period is the amount of time the investment is held by

an investor or the period between the purchase and sale of an asset.
Inventory holding period calculates the number of days in inventory

Days in a year
Inventory holding period = ------------------------------------
Inventory turnover ratio

 Debtors turnover ratio:

The debtor’s turnover ratio is an activity ratio measuring how

efficiently a firm uses its assets. It evaluates the ability of a company to
efficiently issue credit to customers and collect funds from them in a
timely manner.
Credit sales
Debtors turnover ratio = -------------------------------------
Average debtors
 Debtor holding period:

The ratio indicates to what extent the debts have been collected
in time. This ratio is a good indicator to the lenders of the firm.
Days in a year
Debtor holding period = -----------------------------------
Debtor turnover ratio
 Creditors turnover ratio:
The creditor’s turnover ratio indicates that how many times a
company pays off its suppliers during an accounting period.

Credit purchases
Creditor turnover ratio = ---------------------------------
Average creditors

 Creditor holding period:

Creditor holding period is a period during which the creditors are

paid. The average time taken by a company in making payments to its
creditors.
Days in a year
Creditors holding period = ---------------------------------------
Creditor’s turnover ratio